Europe as a major risk to the US economic outlook

Download PDF In the year ahead, a more than likely intensification of the European debt crisis constitutes the major external risk to the US economic outlook. This is partly because US export prospects will be negatively impacted by a marked weakening in the Euro and by a serious economic recession in Europe, which still constitutes around one-third of the overall global economy. More troubling yet, it is because a potential European banking crisis would spill over to the US financial system, which has very close links to the European banking system.

Over the past year, there has been a major deterioration in the European economic outlook:

Greece’s economy is now literally in freefall, as indicated by a more than 14 percent decline in GDP from its 2008 peak and by a rise in unemployment to 18 ½ percent. As a result, the country is on the verge of becoming politically ungovernable. The country is also now on the cusp of  a disorderly default, which could involve writing down the net present value of Greece’s privately-held sovereign debt by over 70 cents on the dollar. This is very likely to cause contagion to the rest of the periphery.

The European crisis has now spread well beyond Greece, Ireland, and Portugal to core countries like Italy and Spain, Europe’s third and fourth largest economies, respectively. Meanwhile there is every indication that Portugal will soon be facing debt-servicing problems similar to those now being experienced by Greece.

Europe is now at the start of a meaningful credit crunch. For its banking system is now engaged in a major deleveraging of its balance sheet in response to large loan losses. The European banks are doing so to meet the official requirement to raise their Tier 1 capital asset ratio to 9 percent by June 2012 to remedy an officially estimated EUR 115 billion capital shortfall.

"Core Europe is now moving towards economic recession."--Desmond Lachman

Core Europe is now moving towards economic recession. After growing by around 3 percent in early 2011, the German economy is officially estimated to have contracted by 0.25 percent in the last quarter of the year and is officially projected to remain flat in the first quarter of 2012. The IMF’s latest World Economic Outlook forecasts that the overall European economy will shrink by 0.5 percent in 2012.

There is now every prospect that the European economy will experience a severe economic recession in 2012 as countries in its periphery continue to struggle with major public finance and external imbalances within the straightjacket of the Euro. In an attempt to restore fiscal sustainability, countries like Spain, Portugal, and Ireland are all aiming at reducing their budget deficit to GDP ratios by over 3 percentage points a year in 2012 and 2013. Meanwhile, in an attempt to prevent its public debt to GDP ratio from rising beyond its present level of 120 percent, Italy is aiming at reducing its budget deficit by 2 percent of GDP a year in both 2012 and 2013.

By now we should have learnt from Greece’s experience over the past two years that major budget adjustment is extremely difficult within the straightjacket of Euro membership. This is because Euro membership precludes an individual country from devaluing its currency to boost exports as an offset to the very negative consequences on output of severe fiscal tightening. This is likely to prove to be all the more so the case for Ireland, Italy, Portugal, and Spain, which are all now trying to effect major budget adjustment in the context of a weak external environment and at a time of a meaningful credit crunch.

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Desmond Lachman is a resident fellow at AEI